Assignment 1: Presenting the Final Plan

TABLE OF CONTENTS:

I. Overview

II. Assumptions

III. Cash Budget

IV. Mix of Debt & Equity

V. Recommendations for Solutions to Financing Needs

VI. Observations & Recommendations for Operational Changes

VII. Conclusion

OVERVIEW:

As Genesis plans operational and product expansion, it finds itself in need of options for acquiring capital to fund the process. The summary begins with Genesis team’s evaluation of historical data and subsequent assumptions that will drive the process. Born of these assumptions we formulate a cash budget detailing inflow and outflow of cash, and estimating financial needs for the planned expansion, with an eye to the importance of the mix of debt and equity financing comprising the capital structure. Recommended short- and long-term solutions coupled with cost estimates will be presented, as well as recommended operational changes.

ASSUMPTIONS:

1. Sales: Genesis’ marketing expert and its Customer Service personnel developed sales projections based on historical data and forecast research.

2. Other cash receipts is rental income of $15,000 per month.

3. Production Material: the Production Manager forecasted materials costs based on quotes from vendors, averaging 50% of sales.

4. Other production costs: based on historical cost data average 30% of the material cost in the month after the material purchase.

5. Selling & Marketing Expenses: are 5% of sales.

6. General & Administrative Expenses: calculated at 20% of sales.

7. Interest payments: $75,000 payable in Dec.

8. Tax payments: quarterly, $15,000

9. Minimum cash balance desired: $25,000 per month.

10. Cash balance at the start of December: $15,000.

11. Available short-term interest rate = 8%, long-term debt rate = 9%, long-term equity 10%.

Utilizing these assumptions, we formulate Genesis’ Cash Budget to gain a detailed view of cash inflows and outflows, and the surplus deficits (mostly) incurred on a monthly basis for the initial forecasting period of one year, and on a quarterly basis for the subsequent year’s forecast.

CASH BUDGET:

In general, the cash budget demonstrates overall losses throughout the first forecasting period. In the second period (year 2) the higher sales from the prior months of September, October and November result in gains rather than losses. After subtracting outflow from inflow, and allowing for the $25,000 desired minimum monthly cash balance, we arrive at the dollar amount of capital needed on a monthly basis for the first year (totaling $3,775,000 at year’s end), and on a quarterly basis for the second year (totaling $4112400 for the two years together). Observations regarding the time value of money, specifically as it pertains to the lack of speed in Genesis’ payment collection schedules, and regarding overall costs will be made at the close of this summary. (Note, for quarterly payment collections calculations, I used ½ (.33) of the quarter’s sales where one of the quarter’s monthly collections fell, and 2/3 (.66) when two months fell into the calculations.

Genesis’ Cash Budget appears as follows:

MIX of DEBT & EQUITY:

The mix of debt financing and equity financing is important when considering the capital structure of the firm. A definition of both forms of financing may be in order. Debt financing is when the firm acquires debt through bank loans or loans from other creditors, or sells bonds. Equity financing is when the firm sells various types of stocks, which, it is important to note, mandates that shareholders receive voting rights in most cases, as well as other rights including the right to purchase assets given over to a lender in the case of default on a loan and/or bankruptcy.

In the case of debt financing, it is important to understand that the heavier the debt ratio in the capital structure, the higher the firm’s beta rating, and the higher the stock’s expected rate of return. Beta is at the heart of expected return ratings, just as higher expected rates of return at the heart of investor/shareholder confidence, which in turn is at the heart of the success of the stock market. Most stock falls between .5 and 1.5 beta, with less than 1 less risky, and more than 1 more risky.

In the case of equity financing, the firm’s original owners take a serious risk that new issue shareholders (or any shareholders in periods past the initial expansion phase of the firm) will exercise their voting rights and possibly adversely affect the decision-making process in terms of the direction, growth, financing and operations/profitability of the firm.

RECOMMENDATIONS FOR SOLUTIONS TO FINANCING NEEDS (and their related costs):

Both long-term debt and financing are recommended.

Long-term debt through the sale of Genesis corporate bonds is recommended as the largest portion of financing in the capital structure, in the par value amount of $2 million. We will sell 2,000 bonds at $1,000 each. Since Genesis is a fledgling company poised on the brink of explosive growth, but without any historical data to speak of, the firm is then a high credit-risk (default risk) resulting in a coupon interest rate of 9% per year interest, including the inflation premium. Genesis will agree to make biannual interest payments of $90,000 in May and November yearly until such time as the bonds reach maturity (we will say 10 years) whereby Genesis will pay in full on both the principal and interest. The total cost for borrowing the $2 million will be $1,800,000. However, the short-term impact is good for the firm’s financial needs right now, as only interest will be paid until the maturity period is reached. To mitigate the risk of immediate financial loss in the event of bonds being called by the investors, Genesis will seek call protection for 5 years, after which the annual interest rate divided by the number of years (beginning with 6 in this case) from the issuance date will give a declining rate of payout.

Long-term equity financing is recommended in the form of Long-term Equity Anticipation Securities (LEAPS) with a three-year maturity period and a much longer than the six-month average expiration date, making them attractive to portfolio investors who want long-term protection for their portfolio. Generally one share equals one vote, so we will try to sell the shares at as high a strike price as possible. In order to raise $1,112,400, Genesis will need to sell 17,138 shares at $65 per share. There will be no immediate cost for dividends, until such time as the stocks mature, giving Genesis time to expand and begin reaping the financial rewards of that expansion before the dividend expenses hit the cash budget.

Genesis can also utilize the capital-raising vehicle of sale of 11,111 common Class A & 10,204 Class B stocks for $45 and $49 respectively. The Class B stockholders will retain their rights, and such stock would generally be sold to the original owners of the company. Class A common shareholders would not be able to vote or exercise their options until the stock matures in a 2 year period, thus protecting the rights of the owners to “drive the bus” figuratively speaking until the fledgling company is solidly on a consistent, positive financial gains path.

A few short-term solutions are in order as well. Since Genesis is bidding for contracts overseas, it is recommended that it purchase a currency put option, allowing them to sell, for example, 12 million euros for a fixed price of $1.50 per euro in nine months. In this way, Genesis can lock in the future exchange rate so that if it wins its bids for overseas business, it will not lose money if the exchange rate takes a turn for the worse. Genesis can also just let the put option expire without losing a dime if it does not win its bid for the overseas business.

Another short-term option is to offer option grants with a two-year vesting period to employees as part of their compensation packages, which bears the advantage of reducing wages (cash outflow) and increasing profits for the duration of the two-year vesting period. The short-term cost of this solution is negligible, amounting to only administration costs, while the cash wage savings realized can be substantial.

OBSERVATIONS & RECOMMENDATIONS FOR OPERATIONAL CHANGES:

Genesis’ Purchasing personnel, whether it be the Production Manager or someone higher in the corporate echelon must utilize solid relationships with trusted vendors to put pressure on the entire supply chain to lower the cost of materials, whether the solution be vendor changes at any point on the chain, or production or supply changes. For example, perhaps widgets could be purchased at $2 instead of $3, or perhaps the producer of widgets could outsource the production to China and reduce the price even more to $1.50. There are a myriad of possibilities when pricing pressure is brought to bear on a supply chain, particularly in a production environment.

In addition, Genesis’ own production process should be reviewed in the light of cost reduction as well. Perhaps idle time of the machines is affecting costs, or overtime, or a poor periodic maintenance schedule and performance is leading to consistent breakdowns, hence a loss of production time, labor dollars spent, and repair and replacement costs.

Finally, General & Administrative Expenses can surely be reduced, if only in terms of office supplies and such. Who is reviewing purchases? Does Dorothy really need an $18 stapler twice a year? Could Genesis put a coin-operated soda machine in the break room instead of supplying beverages? Is there a more inexpensive brand of printer paper? Is Genesis recycling toner cartridges with the incumbent price break given? There are generally many ways to reduce expenses in this category if careful ordering, receiving, and declining budget procedures are followed.

If Genesis reduced material costs to 40% of sales, additional costs to 25% of sales, and General & Administrative Expenses to .18% of sales, the resulting savings over the two-year period would cover capital needs, leaving only $787,000 outside funding needed. Truly, this is the route we recommend.

The following is the Cash Budget with the aforementioned operational changes:

If Genesis also sped up collection time, they would have more money, sooner, to cover needs for expansion funding. The financial picture is particularly grim in the original Cash Budget. Note that each month ends with a loss until the first quarter of the second year. Time truly is money, and the present value of future cash streams is a vital figure – the value of money diminishes over time. It is easier to attract investors when the expected rate of return is high and is immediate enough. Otherwise, they might as well buy and store commodities (assets, like gas or gold) rather than invest in a losing proposition.

The Cash Budget with operational processes revised and a speed of payment of customer collections of 20% within the first month and 50% within the second month results in a total financing need amount of $375,500 for the two year period. It appears as follows (note the quick positive gains beginning early in the first year rather than early in the second year, as with the original Cash Budget):

CONCLUSION:

Though revision of operational processes and faster payment collection are recommended so that Genesis may internally finance a large portion of its capital funding needs, some financing needs still exist. It is still recommended that Genesis employ a mix of debt and equity financing through issuance of bonds and common stock as outlined above. Capital will always be an important part of growing the firm, and both long-term and short-term financing as well as debt and equity financing, should play a part in the capital structure. It is important to understand the costs and benefits of each, as explained in this summary, and to how the fit into the timeline of capital needed per forecast period. Only then can those “driving the bus” make informed decisions regarding capital structure that will result in growth, profits, and more growth.

Resources:

Brigham, E., Ehrhardt, M., Financial Management Theory & Practice, 13th ed., 2011

Genesis Cash Budget ($000)

DecJanFebMarchAprilMayJuneJulyAugSeptOctNovDecMarchJuneSeptDec

Cash Inflow

Sales (Reference only)

300,000200,000350,000400,000500,000550,000700,000700,000650,000900,000850,000750,000500,000150,000190,0003,000,0002,400,000

Cash Collections on Sales

10% in month of sale

30,00020,00035,00040,00050,00055,00070,00070,00065,00090,00085,00075,00050,00015,00019,000300,000240,000

25% in first month after sale

75,00050,00087,500100,000125,000137,500175,000175,000162,500225,000212,500187,500149,75043,725510,675643,500

35% in second month after sale

105,00070,000122,500140,000175,000192,500245,000245,000227,500315,000297,500454,82566,125405,0002,460,000

30% in third month after sale

90,00060,000105,000120,000150,000165,000210,000210,000195,000270,000630,00045,00057,000900,000

Other Cash Receipts

15,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00045,00045,00045,00045,000

Total Cash Inflow

45,000110,000205,000302,500347,500440,000517,500602,500665,000722,500762,500812,500820,0001,294,575218,8501,317,6754,288,500

Cash Outflows

Material Purchases (reference only)

150,000100,000175,000200,000250,000275,000350,000350,000325,000450,000425,000375,000250,00075,00095,0001,500,0001,200,000

Payment for Material Purchase

150,000100,000175,000200,000250,000275,000350,000350,000325,000450,000425,000375,00075,00095,0001,500,0001,200,000

100% in month after purchase

Other Cash Payments

Other production cost 30%

45,00030,00052,50060,00075,00082,500105,000105,00097,500135,000127,500112,50022,50028,500450,000360,000

of Material cost paid month

after Purchase

Selling and Marketing Expense

15,00010,00017,50020,00025,00027,50035,00035,00032,50045,00042,50037,50025,0007,5009,500150,000120,000

General and Adminstrative expenses

60,00040,00070,00080,000100,000110,000140,000140,000130,000180,000170,000150,000100,00030,00038,000600,000480,000

Interest Payment

75,000 75,000

Tax Payment

15,00015,00015,00015,00015,00015,00015,000

Dividend Payment

00000000000000000

Total Cash Outlfows

150,000245,000217,500327,500400,000462,500532,500645,000617,500647,500812,500740,000612,500150,000186,0002,715,0002,250,000

Net Cash Gain/(Loss)

-105,000-135,000-12,500-25,000-52,500-22,500-15,000-42,50047,50075,000-50,00072,500207,5001,144,57532,850-1,397,3252,038,500

Cash Flow Summary

Cash Balance start of the month

15,000-90,000-225,000-237,500-262,500-315,000-337,500-352,500-395,000-347,500-272,500-322,500-250,000-42,5001,102,0751,134,925-262,400

Net Cash Gain/loss

-105,000-135,000-12,500-25,000-52,500-22,500-15,000-42,50047,50075,000-50,00072,500207,5001,144,57532,850-1,397,3252,038,500

Cash Balance at end of month

-90,000-225,000-237,500-262,500-315,000-337,500-352,500-395,000-347,500-272,500-322,500-250,000-42,5001,102,0751,134,925-262,4001,776,100

Minium cash Balance desired

25,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00075,00075,00075,00075,000

Surplus cash (deficit)

-115,000-250,000-262,500-287,500-340,000-362,500-377,500-420,000-372,500-297,500-347,500-275,000-67,5001,027,0751,059,925-337,4001,701,100

External Financing Summary

External Financing Balance

at start of month

New Financing Required

115,000250,000262,500287,500340,000362,500377,500420,000372,500297,500347,500275,00067,50000337,4000

(negative amount from cash

suplus (deficit)

External Financing Requirement

115,000250,000262,500287,500340,000362,500377,500420,000372,500297,500347,500275,00067,50000337,4000

External Financing Balance

115,000365,000627,500915,0001,255,0001,617,5001,995,0002,415,0002,787,5003,085,0003,432,5003,707,5003,775,0003,775,0003,775,0004,112,4004,112,400

Monthly BudgetQuarterly Budget

Genesis Cash Budget ($000)

DecJanFebMarchAprilMayJuneJulyAugSeptOctNovDecMarchJuneSeptDec

Cash Inflow

Sales (Reference only)

300,000200,000350,000400,000500,000550,000700,000700,000650,000900,000850,000750,000500,000150,000190,0003,000,0002,400,000

Cash Collections on Sales

10% in month of sale

30,00020,00035,00040,00050,00055,00070,00070,00065,00090,00085,00075,00050,00015,00019,000300,000240,000

25% in first month after sale

75,00050,00087,500100,000125,000137,500175,000175,000162,500225,000212,500187,500149,75043,725510,675643,500

35% in second month after sale

105,00070,000122,500140,000175,000192,500245,000245,000227,500315,000297,500454,82566,125405,0002,460,000

30% in third month after sale

90,00060,000105,000120,000150,000165,000210,000210,000195,000270,000630,00045,00057,000900,000

Other Cash Receipts

15,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00045,00045,00045,00045,000

Total Cash Inflow

45,000110,000205,000302,500347,500440,000517,500602,500665,000722,500762,500812,500820,0001,294,575218,8501,317,6754,288,500

Cash Outflows

Material Purchases (reference only)

120,00080,000140,000160,000200,000220,000280,000280,000260,000360,000340,000300,000200,00060,00076,0001,200,000960,000

Payment for Material Purchase

120,00080,000140,000160,000200,000220,000280,000280,000260,000360,000340,000300,00075,00095,0001,500,0001,200,000

100% in month after purchase

Other Cash Payments

Other production cost 30%

30,00020,00035,00040,00050,00055,00070,00070,00065,00090,00085,00075,00015,00019,000300,000240,000

of Material cost paid month

after Purchase

Selling and Marketing Expense

15,00010,00017,50020,00025,00027,50035,00035,00032,50045,00042,50037,50025,0007,5009,500150,000120,000

General and Adminstrative expenses

54,00036,00063,00072,00090,00099,000126,000126,000117,000162,000153,000135,00090,00027,00034,200540,000432,000

Interest Payment

75,000 75,000

Tax Payment

15,00015,00015,00015,00015,00015,00015,000

Dividend Payment

00000000000000000

Total Cash Outlfows

144,000196,000180,500267,000330,000376,500436,000526,000499,500532,000660,500597,500490,000139,500172,7002,505,0002,082,000

Net Cash Gain/(Loss)

-99,000-86,00024,50035,50017,50063,50081,50076,500165,500190,500102,000215,000330,0001,155,07546,150-1,187,3252,206,500

Cash Flow Summary

Cash Balance start of the month

15,000-84,000-170,000-145,500-110,000-92,500-29,00052,500129,000294,500485,000587,000802,0001,132,0002,287,0752,333,2251,145,900

Net Cash Gain/loss

-99,000-86,00024,50035,50017,50063,50081,50076,500165,500190,500102,000215,000330,0001,155,07546,150-1,187,3252,206,500

Cash Balance at end of month

-84,000-170,000-145,500-110,000-92,500-29,00052,500129,000294,500485,000587,000802,0001,132,0002,287,0752,333,2251,145,9003,352,400

Minium cash Balance desired

25,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00075,00075,00075,00075,000

Surplus cash (deficit)

-115,000-195,000-170,500-135,000-117,500-54,00027,500104,000269,500460,000562,000777,0001,107,0002,212,0752,258,2251,220,9003,277,400

External Financing Summary

External Financing Balance

at start of month

New Financing Required

115,000195,000170,500135,000117,50054,00000000000000

(negative amount from cash

suplus (deficit)

External Financing Requirement

115,000195,000170,500135,000117,50054,00000000000000

External Financing Balance

115,000310,000480,500615,500733,000787,000787,000787,000787,000787,000787,000787,000787,000787,000787,000787,000787,000

Monthly BudgetQuarterly Budget

Genesis Cash Budget ($000)

DecJanFebMarchAprilMayJuneJulyAugSeptOctNovDecMarchJuneSeptDec

Cash Inflow

Sales (Reference only)

300,000200,000350,000400,000500,000550,000700,000700,000650,000900,000850,000750,000500,000150,000190,0003,000,0002,400,000

Cash Collections on Sales

10% in month of sale

30,00020,00035,00040,00050,00055,00070,00070,00065,00090,00085,00075,00050,00015,00019,000300,000240,000

25% in first month after sale

150,000100,000175,000200,000250,000275,000350,000350,000325,000450,000425,000375,000299,50087,4501,021,3501,287,000

35% in second month after sale

105,00070,000122,500140,000175,000192,500245,000245,000227,500315,000297,500454,82566,125405,0002,460,000

30% in third month after sale

90,00060,000105,000120,000150,000165,000210,000210,000195,000270,000630,00045,00057,000900,000

Other Cash Receipts

15,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00015,00045,00045,00045,00045,000

Total Cash Inflow

45,000185,000255,000390,000447,500565,000655,000777,500840,000885,000987,5001,025,0001,007,5001,444,325262,5751,828,3504,932,000

Cash Outflows

Material Purchases (reference only)

120,00080,000140,000160,000200,000220,000280,000280,000260,000360,000340,000300,000200,00060,00076,0001,200,000960,000

Payment for Material Purchase

120,00080,000140,000160,000200,000220,000280,000280,000260,000360,000340,000300,00075,00095,0001,500,0001,200,000

100% in month after purchase

Other Cash Payments

Other production cost 30%

30,00020,00035,00040,00050,00055,00070,00070,00065,00090,00085,00075,00015,00019,000300,000240,000

of Material cost paid month

after Purchase

Selling and Marketing Expense

15,00010,00017,50020,00025,00027,50035,00035,00032,50045,00042,50037,50025,0007,5009,500150,000120,000

General and Adminstrative expenses

54,00036,00063,00072,00090,00099,000126,000126,000117,000162,000153,000135,00090,00027,00034,200540,000432,000

Interest Payment

75,000 75,000

Tax Payment

15,00015,00015,00015,00015,00015,00015,000

Dividend Payment

00000000000000000

Total Cash Outlfows

144,000196,000180,500267,000330,000376,500436,000526,000499,500532,000660,500597,500490,000139,500172,7002,505,0002,082,000

Net Cash Gain/(Loss)

-99,000-11,00074,500123,000117,500188,500219,000251,500340,500353,000327,000427,500517,5001,304,82589,875-676,6502,850,000

Cash Flow Summary

Cash Balance start of the month

15,000-84,000-95,000-20,500102,500220,000408,500627,500879,0001,219,5001,572,5001,899,5002,327,0002,844,5004,149,3254,239,2003,562,550

Net Cash Gain/loss

-99,000-11,00074,500123,000117,500188,500219,000251,500340,500353,000327,000427,500517,5001,304,82589,875-676,6502,850,000

Cash Balance at end of month

-84,000-95,000-20,500102,500220,000408,500627,500879,0001,219,5001,572,5001,899,5002,327,0002,844,5004,149,3254,239,2003,562,5506,412,550

Minium cash Balance desired

25,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00025,00075,00075,00075,00075,000

Surplus cash (deficit)

-115,000-120,000-45,50077,500195,000383,500602,500854,0001,194,5001,547,5001,874,5002,302,0002,819,5004,074,3254,164,2003,637,5506,337,550

External Financing Summary

External Financing Balance

at start of month

New Financing Required

115,000120,00045,500-77,500-195,000-383,50000000000000

(negative amount from cash

suplus (deficit)

External Financing Requirement

115,000120,00045,500-77,500-195,000-383,50000000000000

External Financing Balance

115,000235,000280,500203,0008,000-375,500-375,500-375,500-375,500-375,500-375,500-375,500-375,500-375,500-375,500-375,500-375,500

Monthly BudgetQuarterly Budget